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Why The S&P 500 Is Likely To Revisit The Correction Lows Near 1870

In spite of the Fed’s decision to refrain from a borrowing cost hike, SPY’s price movement strongly suggests the ultra-accommodating policy of zero percent interest rates may be inadequate. We’re likely heading back to the recent low point for the current year. The reality is that our recovery is stalling and has been since the end of the Fed’s quantitative easing stimulus. In Selling The Drama Or Buying The Rally (8/27), I delineated the way in which 10%-plus price corrections had unfolded under similar circumstances in history (e.g., 1998, 2010, 2011, etc.). Specifically, when the prospects for the global economy are deteriorating, U.S. stock benchmarks typically reclaim about one-half of their losses on “hope rallies.” Afterwards, they retest their lows. The most recent example of the price movement phenomenon is the eurozone crisis. In late July/early August of 2011, the S&P 500 SPDR Trust ETF (NYSEARCA: SPY ) plunged 16% due to fears surrounding economic malaise and financial credit concerns in Portugal, Italy, Greece and Spain. The popular ETF then recovered one-half (nearly 8%) of its price decline in late August/September before revisiting new lows in early October. At that point, the European Central Bank (ECB) and the Federal Reserve dropped market-moving hints about extraordinary stimulus measures, effectively ending the panicky price depreciation. In the same vein, the present corrective phase for SPY stopped short at roughly 12%. The popular ETF then retraced about one-half of the price erosion (6%) on two recent occasions. And now, in spite of the Federal Reserve’s decision to refrain from a borrowing cost hike (probably for 2015 in its entirety), SPY’s price movement strongly suggests that the ultra-accommodating policy of zero percent interest rates may be inadequate; that is, we’re likely heading back to the recent low point of the current year. Shouldn’t the Fed’s September decision to hold off any increases in borrowing costs have catapulted the U.S. stock market higher? Shouldn’t we have seen speculative buying demand for riskier assets like high yield bonds and growth stocks? Not when the U.S. has been contending with a sharp slowdown in exports, manufacturing activity as well as consumer sentiment. Not when the Atlanta Fed forecasts anemic GDP of 1.5% for the third quarter. And not when chairwoman Janet Yellen acknowledges the absence of wage inflation as well as the the presence of labor troubles via the labor participation rate. Prior to the rapid-fire declines for the Dow, S&P 500 and Nasdaq in mid-August, I detailed these economic concerns in extraordinary detail. I highlighted the dreadful manufacturing data in the Philly Fed Survey as well the Empire State Manufacturing Survey in 15 Warning Signs Of A Market Top . On, July 30th, I pointed to economic weakness in both the U.S. and across every region of the globe as being one of 5 reasons to lower one’s allocation to riskier assets . Going into yesterday’s (9/17) monumental Fed decision, traders had been positioning themselves for further delay on an increase in borrowing costs. They got it. And yet, they got more than they had bargained for. Not only did the Fed highlight weakness in the global economy as a potential threat to the domestic economy, but they shot down the notion of so many economists and analysts that the U.S. economy is standing on “terra firma.” For amusement, revisit what the overwhelming majority of journalists and media personalities had been saying about the strength of the U.S. economy. After, glance at the analysis and commentary a day later. The chief economist at Natixis Asset Management explained that the Fed’s decision not to act demonstrates that committee members of the central bank clearly think that the U.S. economy is “very weak.” Oh really? Now the economy is very weak? Or how about Dan Veru, chief investment officer at Palisade Capital Management, explaining that the Fed doesn’t want to be responsible for possibly unraveling a “fragile recovery.” Fragile recovery? After six-and-and-a-half years? Wasn’t this the great U.S. expansion that was perfectly capable of a modest move away from the emergency level zero bound? Sometimes, the truth hurts. The reality is that our recovery is stalling and has been since the end of the Fed’s quantitative easing stimulus. This truth is painful for everyday Americans. The fact that corporate sales and earnings growth are both on the decline also stings because, absent a more definitive Fed commitment to zero rate policy or more stimulus or a sloth-like token hike, riskier assets are likely to struggle. In essence, at certain correction levels, the Federal Reserve tends to take certain actions and/or make certain statements to boost market confidence. That level for the S&P 500 is near 1870. Obviously, I cannot know that the S&P 500 will revisit 1870, but I believe it is far more probable than not. Let me repeat. I anticipate the broader S&P 500 retesting the lows of the current correction, though it is impossible for any person to predict the direction of stock assets. For those moderate growth/income investors that have been emulating the tactical asset allocation that I do for actively managed clients, we are maintaining the lower risk profile of 50% equity (mostly large-cap domestic), 25% bond (mostly investment grade) and 25% cash/cash equivalents. This has been the case since we began reducing risk exposure in June-July. The typical target allocation for moderate growth/income of 65%-70% stock (e.g., large, small, foreign, domestic) and 30% income (e.g., investment grade, high yield, short, long, etc.) will not be reestablished until market internals and fundamentals show signs of improvement. Popular holdings for the 50% equity component? We have ETFs like iShares S&P 500 (NYSEARCA: IVV ), iShares USA Minimum Volatility (NYSEARCA: USMV ), SPDR Select Health Care (NYSEARCA: XLV ) and Vanguard Mid Cap Value (NYSEARCA: VOE ). Funds like USMV and VOE have weathered the storm better than many of the leading market-cap-weighted benchmarks. Disclosure : Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

Homebuilding On Sustained Growth: ETFs In Focus

After a sizzling summer, the U.S. housing market showed signs of losing some momentum, indicating that the China-led global growth worries might have spoiled the industry’s growth last month. This is especially true as new home construction dropped 3% in August to a seasonally adjusted annual rate of 1.13 million homes, much higher than the market expectation of 1.16 million. Despite the fall, housing starts remained above the one-million-unit mark for the fifth straight month. This suggests that recovery is still on the way and will keep coming. The positive sentiments were driven by growing demand for homes, accelerating job growth, rising wages, affordable mortgage rates, and increasing consumer confidence. Additionally, new applications for building permits, a construction bellwether for the coming months, rebounded last month as it rose 3.5% to an annual rate of 1.17 million after falling 15.5% in July. Another data showed that homebuilder confidence jumped to the highest level since November 2005 as indicated by the National Association of Homebuilders/Wells Fargo Sentiment Index that rose one point in September. The optimism is also reflected in number of homebuilder stocks and ETFs. In particular, the iShares U.S. Home Construction ETF (NYSEARCA: ITB ) and the SPDR Homebuilders ETF (NYSEARCA: XHB ) gained about 0.8% each on Thursday’s trading session despite the disappointing housing starts data. This was followed by a modest 0.04% gain for the PowerShares Dynamic Building & Construction Portfolio ETF (NYSEARCA: PKB ) . From a year-to-date look, ITB, XHB and PKB have respectively risen 10%, 9.4% and 14.3%, and are easily outpacing the broad sector and broad market funds. XLB lost nearly 10.3% while SPY shed 1.74% in the same time frame. All the three ETFs have a decent Zacks ETF Rank of 3 or “Hold” rating with a High risk outlook. The outperformance in the homebuilding space is likely to continue in the coming months given that the residential and commercial building industry has a solid Zacks Rank in the top 38%. Further, S&P Capital IQ expects homebuilding revenues to increase 15% this year and 11% in the next, thanks to encouraging industry fundamentals and an improving U.S. economy. Investors seeking large profits in a short span could also take a look at the leveraged plays – the ProShares Ultra Homebuilders & Supplies ETF (NYSEARCA: HBU ) and the Direxion Daily Homebuilders & Supplies Bull 3x Shares ETF (NYSEARCA: NAIL ) . HBU provides double exposure while NAIL offers triple exposure to the index of ITB. However, the fund is relatively new in the space and has low trading activity, making it a riskier and a high-cost choice. Link to the original post on Zacks.com Share this article with a colleague

Why Comparing Returns Is A Bad Way To Choose An Investment Manager

Summary Short-term or recent returns give little information about future returns, and they increase the odds you’ll make a bad decision. Far too often, investors put significant weight on short-term performance, in many cases by choosing the investment with the highest recent investment return. This tends to actually produce future underperformance. The better way to choose an investment manager is to look at service, fit, and investor returns. The greatest trick the stock market ever pulled was convincing investors that historical returns are predictive. They aren’t. In fact, historical returns not only give you very little information about future returns, but they can also increase the odds you’ll make a bad decision. We often see this bias in investors. Both reporters and prospective customers often ask us, “What are your returns?” I cringe when I hear this. Out of all the questions you should be asking, this one should be low on the list. There are far more informative and useful questions to ask, once you know what’s in our portfolio . To be fair, there are aspects of the answer that can be helpful. Returns can give you an idea of the size of upswings and drawdowns, and how the portfolio relates to other asset classes. But in a passive, index-tracking portfolio, such as Betterment’s, you shouldn’t expect to see market alpha in our performance. When properly benchmarked, we are the benchmark. The other common mistake people make is comparing our portfolio to another over a short period of time. If, after six months, our portfolio has a lower return, they’ll often ask, “Why should I use you if your returns are worse?” Far too often, investors put too much weight on small sample, recent historical performance, choosing the investment with the highest investment return. How deceptive can this be? Our interactive tool below shows that this method leads to astonishingly high odds that they’ll underperform both in absolute and risk-adjusted terms in the future. How the Data Deceives You might not realize it, but when you look at historical returns, you’re doing a statistical analysis. Any set of historical returns comprises a sample of behavior over a certain period. Any inferences you make about what they tell you of the future should be balanced by placing them into context of how variable they are. And when you do that, two clear issues arise. Fooled by Randomness The first is being “fooled by randomness,” a phrase coined by Nicholas Nassim Taleb, a risk analyst and statistician. When you choose the highest returning of two correlated investments using a small sample of historical data, the odds are incredibly high that you picked the wrong fund. The randomness of small samples overwhelms the truth. Let’s work through some examples. We’ll use hypothetical portfolios with return probabilities we know for certain, because we’ve created them through simulation, and see how well the short-term data mimics the long-term truth. These are not Betterment portfolios. Portfolio A will have a mean annual return of 6% and a volatility of 14%. Portfolio B has a mean return of 6.5% and annual volatility of 13%. The portfolios will also have a 0.90 correlation to each other-most stock funds have higher correlations. By both measures of absolute return and risk-adjusted return, Portfolio B is better. Yet over the first randomly simulated six-month period, Portfolio A came out ahead. One 6-Month Simulation (click to enlarge) How often does the worse portfolio come out ahead over a short time period? In this case, we’ll call them C and D, with the same parameters. Let’s look at running 1,000 of such simulations over a six-month period. How often does Portfolio D, who should be the winner, come out ahead? Many Simulations Over 6 Months (click to enlarge) The answer is so close to 50% as to be indistinguishable from it. In fact, we can increase the differences in expected returns and this remains true. Let’s give Portfolio D a mean return of 8% and Portfolio C a mean return of 6%. Both have 14% volatility. The significantly higher return Portfolio D will still lose over 40% of the time over a six-month period. Many Simulations Over 6 Months (click to enlarge) While the odds are just better than 50/50 in the short term, they have big consequences in the long term. Here are the distributions of 20-year outcomes for those same portfolios: Many Simulations Over 20 Years (click to enlarge) The randomness in half-year returns results in choosing the wrong portfolio about half the time, even with large difference in return. You might as well save yourself the time and expense and flip a coin. Over long periods of time (20 years), and with large differences in average returns, the odds of picking the correct choice do increase. But you may be surprised how long it can take. For portfolios with a 1% return difference, by 20 years you still have about a one-in-four chance of picking the portfolio that will have worse underlying returns over even longer periods of time. Chance of Choosing Worse Portfolio Based on Performance Return Difference 3 months 6 months 1 Year 5 Years 10 Years 20 Years 0.50% 49% 48% 48% 42% 40% 37% 1.0% 47% 46% 44% 36% 32% 26% 2.0% 44% 43% 37% 26% 16% 9% Each cell based on 3,000 simulated cumulative returns of better portfolio (8% return) versus a benchmark portfolio with a mean return of 6% and 14% volatility. Correlation of 0.90 between portfolios. To be clear, there are statistical tools you can use to improve your odds of picking the right portfolio, but most investors aren’t professional statisticians. They just go by the cumulative returns over a short period of time. Performance Chasing Is Worse Than Random If the low odds of correctly choosing a better portfolio above didn’t convince you, it’s even worse than that. Empirically, choosing the best funds, a strategy called performance chasing, is likely to reduce your returns. The graph below comes from an excellent research paper from Vanguard. It shows the returns achieved by investing in the best fund in each asset class, compared to a buy-and-hold strategy. Performance chasing-picking investment based on recent performance-produced worse returns of about -2% to -3.5%. Buy-and-Hold Superior to Performance Chasing, 2004-2013 (click to enlarge) If every year, you picked the investment manager with above average returns over the past 12 months, you’d end up underperforming an investor who stuck with the passive index-tracking manager. The Right Things to Consider If recent investment performance is such a poor way to choose an investment manager, how should you select one? Use a set of clear principles that are likely to be true in the future: Monetary Cost: A certain drag on returns, if the service doesn’t deliver value above cost. Consider commissions, trade fees, and assets under management (AUM) fees. Non-Money Costs: How much time and and effort does it take for you to use it well? Does it have a high time or stress cost for you to get the most out of it? Services Offered: Do the services offered make you better off? Does it do things for you which you wouldn’t do yourself? Does it help you make better decisions? Does it make some of those decisions for you, automatically? Experience: Is it easy to use? Do you enjoy using it? Philosophy Fit: Consider its investment philosophy, and if it is parallel to yours. Some funds seek to deviate from the index and cost more, some seek to track it passively. Tax Management: Returns will likely not take into account actual value-adds , such as tax loss harvesting. You won’t have received a comparison tax bill that allows you to compare after-tax returns across services; it will be up to you to compare them. Behavior Management: Does the service have a proven track record of reducing the behavior gap? When choosing an investment manager, the key isn’t to focus on investment performance; it’s to focus on service, fit, and investor returns. Information in this article represents the opinion of the author. No statement in this article should be construed as advice to buy or sell a security. The author does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision.